US Housing Relief Plan Underway

The Obama Plan to help homeowners hold onto their houses by refinancing their mortgages is getting underway today. There are three core elements to the program.  All the details are available at: http://www.treas.gov/press/releases/reports/housing_fact_sheet.pdf.

To understand the program, it is important to conceptually separate homeowners into 4 categories. First are people who own their houses free and clear. This group accounts for 31% of all homeowners, and a somewhat lower total value of all housing - about 25%. These folks are obviously not in trouble.

This leaves about 51 million houses with mortgages on them. The 2nd group is those where the current loan-to-value (LTV) is under 80%. These people have the ability to refinance now, and probably should be doing so given that mortgage rates are now at historically low levels. There is no aid being given to this group.

The 3rd group is people with LTVs between 80% and 105%, and this is the group that is the focus of the Obama Plan. They may have had an LTV when they purchased the house of less than 80%, and have been paying their mortgage each month, but in the early years of a mortgage, not much goes to principal. So even if prices had remained flat, after 5 years they would have only been down to about a 75% LTV. But last year, housing prices in the 20 largest metro areas declined by 18.2%, which pushed their LTV well above the 80% level, which has locked these people out of refinancing.

The 80% LTV level is important since most banks will no longer lend at higher levels than that, and even in the past would require that the homeowner take out private mortgage insurance if they were above that threshold. This was also a requirement if the loans were to be bought or backed by Fannie Mae (FNM) or Freddie Mac (FRE), together referred to as the GSEs.

If they could refinance, they could save a lot of money each year. If someone has a $200,000 mortgage at 6.5%, and they were able to refi at the current rate of 5.16%, they would save $2,300 per year. That is almost 3 times the size of the household tax cuts ($800) in the stimulus package. There is a certain amount of luck involved here, since the current mortgage has to be held or backed by FNM or FRE, which are involved with about half of all mortgages. Still, it is estimated that this program could help between 4 and 5 million homeowners.

The downside to this is it means that FNM and FRE will be holding lots of mortgages with high LTVs. These are inherently more risky than low LTV loans. Doing these refis are not without cost. Most investors would rather be holding a mortgage that pays 6.5% than one that pays 5.16%. In short, much of the cost of this is going to be borne by FNM and FRE, and will cause their losses to continue to increase.

To prevent them from collapsing, the government is increasing its holdings of preferred stock in each of the firms to $200 billion from the current $100 billion. The money for doing this is coming out of the Housing and Economic Recovery act, not out of the TARP.

The next part of the program is using the GSEs and the FHA is to try to prevent foreclosures. A total of $75 billion is budgeted for this. This part is focused on people where their mortgage payments are an unreasonably large part of their income. Some of these are people who had initial teaser rates which have since reset, or other exotic mortgages, some who quite frankly committed mortgage fraud by fibbing about how much they made at the time they bought their house, and some who have seen their incomes fall because one or both of the spouses have lost their job.

It only focuses on owner-occupied houses, so it does not reach wannabe mini-real estate moguls who were buying and flipping like crazy during the boom, and is limited to conforming mortgages. Unfortunately, the definition of “conforming” was stretched beyond recognition early last year, and in high-cost areas of the country can be almost $730,000. I thought expanding the conforming limit dramatically was a huge mistake at the time, and I think that history has proven me correct.

Essentially, the existing mortgage holder would have to reduce the payment to 38% of the homeowner’s income, either by reducing the interest rate, extending the term or by reducing the principal. So if the homeowner was paying 43% of his income, the first 5% reduction would be on the bank alone. Then the cost to bring the payment down to 31% would be split 50-50 with the government.

In return, lenders would get $1,000 up front and $1,000 per year for 3 years for each mortgage they modified that stayed current. This is probably the more controversial part of the plan, since it will tend to reward some homeowners that were just plain irresponsible to start with - such as those that lied on their original mortgage applications, or who were banking on huge increases in their incomes in the future to afford the higher rates after the teaser rates expired.

However, if the house next door goes into foreclosure, the value of your house falls significantly, and if you have 3 or 4 houses on your block in foreclosure, you will see a very dramatic drop in the value of your house. It is estimated that this program may help between 3 and 4 million homeowners.

The final element of the plan is to revise the bankruptcy code, so judges can modify the terms of mortgages when the homeowner declares bankruptcy. While the bank lobbyists are up in arms about this proposal, that probably tells you it is a good thing. To hear the Mortgage Bankers Association, you would think that no bank ever made a mortgage on a second home or an investment property, both of which can be modified in bankruptcy.

It is only primary residences that are excluded from being revised by the judge. That, of course, is almost always the biggest debt that the person filing for bankruptcy has. Imagine if the same rule were to apply to corporate bankruptcies - say General Motors (GM) were to file Chapter 11, and the judge were not allowed to modify a union contract or pensions. What would the point of having Chapter 11 be then? It’s not like people are going to declare bankruptcy frivolously. Being in personal bankruptcy is no fun.

Just to put this all in perspective, First American Corelogic is out with a report today estimating that 8.3 million homes, or almost 25% of all homes with mortgages on them, are currently underwater. If housing prices fall another 5%, an additional 2.2 million homes will slip below the waves. Another 5% decline in home values nationwide is almost a certainty at this point, with a further decline of 10 to 15% highly likely.

The total value of all homes in the U.S. fell to $19.1 trillion at the end of 2008, from $21.5 trillion at the end of 2007. Half of the total decline in value was in the state of California. Now, not everyone that is underwater is likely to walk away from their house, but there are 2.2 million homes that are deep underwater, with LTV’s of more than 125%. Those folks are very likely to default, particularly if their mortgage payments are eating up most of what they make. These deep and medium-depth (more than 105% LTV) people are the final group, and quite frankly, will be left to drown.

In short, this plan will not totally solve the mortgage problem, but it will significantly ameliorate it. To the extent that the rate of foreclosures is slowed, it may have more impact on stabilizing the banks than all the cash that is being thrown at them directly. Think of this as another back-door way of benefiting the big banks like Bank of America (BAC) and J.P. Morgan (JPM) but that will also have some benefits for individual homeowners.

While there is plenty of blame to go around - on both the borrower and the lender side - the lenders were the ones who were supposed to be the pros and who were making the big bucks. If we have to unjustly benefit some to save the system, it is better to have some of the benefits go to the borrowers, rather than it all going to the lenders.

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